The Lurking Crisis of Bank Deposits

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1 The Lurking Crisis of Bank Deposits Feb 01, 2016 The Italian banking crisis has moved to its next inevitable stage. European institutions have started to struggle with the question of whether and how to protect deposits in Italian banks. Italy adopted new EU-mandated policies regarding bail-ins in January. The rules for these bail-ins require a bank s shareholders and debt holders to absorb losses before taxpayer money can be used to assist a bank. Deposits of more than 100,000 euros ($109,000) could be affected, but those containing less than 100,000 euros are protected by European deposit guarantees and cannot be touched. As a result, individuals who hold what they believe to be relatively low-risk investments, as well as small businesses that keep more than 100,000 euros on hand, could be at risk. As Italy grapples with the new policies, there is a dispute within the eurozone over who should ultimately be responsible for guaranteeing deposits that, under European laws, are protected even in the case of a bail-in. This is a familiar scenario: the EU once again discovers its original dictum would lead to disaster, so it changes its course to find a solution that is acceptable to all members. In other words, we are now at the point of paralysis. But this time it is paralysis over an issue with catastrophic implications. We can make a distinction between investments and putting money in the bank. Investments are understood to carry with them both opportunities and risks. Putting your money into the bank is not expected to carry either. The benefit of having an individual bank account is to safeguard money. If banks cannot guarantee this safety, then there is little point in putting money in a bank in the first place. In fact, withdrawing funds from an unsound bank becomes a matter of urgency because if enough depositors become uneasy and withdraw their money, the last man to the door may be wiped out. For the middle class, insecurity in banks is an existential crisis. Wealthy individuals and corporations have experience in managing risks. They diversify not only among banks, but among countries or among asset classes. They can be hurt, but rarely completely devastated. Although the middle class may have money in more than one bank, most risk-management tools are both out of their reach and outside their experience. For the middle class in Euro-American culture, banks are where those assets that are accumulated over a lifetime are stored and kept secure. Once they are seen as insecure, various stratagems emerge, from buying homes or gold, to buying foreign currency, to getting the money out of the country. When this occurs on a massive scale, the result is a contraction of lending by banks, bank failure, and depression. But the most important result is the loss of confidence in social and political institutions by the middle class. We are seeing this happen now in some export-oriented countries and some European states. There is a social contract between the middle class and society as a whole, where the middle class agrees to work hard and save their money. In return public institutions guarantee that the fruits of their labor will be secure. If they were to lose their deposits, it would be a financial catastrophe. But the violation of the implicit social contract would lead to political

2 catastrophe. This is why US President Franklin D. Roosevelt, in his first fireside chat, focused on the need to restore confidence in institutions such as banks. Stripping the middle class of their assets or making them afraid this might happen leads to massive political unrest. The fear of loss of deposits is stalking countries besides Italy. As exporters across the globe experience reduced revenues and as the European Union s financial troubles continue, governments in East and Central Asia and across Europe are growing worried about the public s confidence in their banking systems. Reduced confidence would not only have immediate financial consequences, but could also have far-reaching geopolitical implications as the ability of governments to manage growing crises diminishes. Deposit insurance is at the core of government efforts to maintain confidence in banking systems. What sets deposit guarantees apart from other government tools for stabilizing financial systems is that these schemes are a direct pledge to each deposit holder to safeguard some of their assets. The massive crisis that the US financial system faced in the early 1930s led to the creation of the Federal Deposit Insurance Corporation (FDIC), which protects deposits if an FDIC-insured bank or savings association fails. The FDIC is backed by the US government and can insure up to $250,000 in deposits for individuals. Deposit insurance schemes around the globe differ in their design and coverage, but fundamentally they are designed to maintain public confidence in the system. Both the economic crisis facing exporters and the eurozone s ongoing financial difficulties are increasing the significance of deposit insurance. For example, in Azerbaijan, a major energy exporter, deteriorating economic conditions have already led to protests throughout the country. Azerbaijan s government announced on Jan. 28 that the country s central bank may provide financial assistance to the Azerbaijan Deposit Insurance Fund (ADIF) if it is unable to pay compensations to depositors. The statement came after the central bank revoked licenses of six Azerbaijani banks and was likely intended to alleviate fears following their closure. The central bank s pledge to provide extra funding for the ADIF signals that the regime is worried that public confidence in the banking sector could be undermined. Should confidence erode, the out come could be not only a run on the banks and significant disruptions to the country s financial system, but also an erosion of the regime s position. Russia is also experiencing concerns over the public s confidence levels. It is no coincidence that the Russian government took initiatives to help boost guarantees for bank deposits in December 2014, as low world oil prices and sanctions were beginning to have a significant impact on Russia s economy (particularly on the value of its currency). The Kremlin moved to allocate extra funds to the country s Deposit Insurance Agency (DIA) and increase the deposit insurance coverage limit for individuals to 1.4 million rubles, the equivalent of about $18,300 under the current exchange rate. Russia s DIA is a busy entity: over the past two and a half years, the country s central bank has shut down over 150 banks, with many others under crisis watch. In fact, on Jan. 29, Russia's Finance Ministry announced that it is considering requiring bail-ins of large depositors. While

3 the move is designed to help protect the overall stability of the system, it indicates that the ministry expects more significant banks to face bankruptcy. With reduced energy revenues intensifying Russia s economic problems, the importance of deposit insurance as a tool for maintaining public confidence, and therefore limiting social unrest, will grow. Concern over internal stability also played a role in China s decision (in May 2015) to introduce deposit insurance for the country s banking system. Large bank failures are mostly unheard of in China, as the government generally steps in to assist banks and investors and implicitly guarantees deposits, especially at bigger banks. Politically, Chinese decision-makers feel that they cannot allow banks to fail, as such a move would further undermine confidence in the leadership and China s economic system as a whole. Nevertheless, the Chinese government recognized that by implicitly making guarantees, they are also failing to discourage banks and investors from making risky choices. China s decision to introduce deposit insurance, therefore, was designed in part to highlight that there is a limit to government assistance and to encourage better investment decisions. While China s system differs greatly from its Western counterparts, the Chinese leadership also aims to use deposit insurance to boost confidence and stability in its banking sector. In Europe, as in the US, deposit guarantees have become a part of the social contract between the people and the authorities. But the question of which authorities are ultimately responsible for guaranteeing the deposits and thus for safeguarding financial stability has become significant. The future of deposit guarantees is one of the main points of contention between Germany and the eurozone s other members. Currently, there are EU-wide regulations on deposit insurance, but those are implemented on a national level. In November 2015, the European Commission officially presented its proposal for a European Deposit Insurance Scheme (EDIS). Under the plan, a European fund would be created, financed directly by bank contributions, and adjusted for risk. At first, the European fund would only be used if national-level deposit insurance funds exhausted their own resources but, over time, it would take on a greater role and fully insure all national deposit guarantees by Germany opposes the scheme on the grounds that risk within the eurozone has to be reduced before such a risk-sharing plan could be viable. Fundamentally, for Berlin, the EDIS would represent a financial obligation to assist eurozone countries with troubled financial systems. Countries such as Italy support the plan because it would provide a much stronger layer of security for depositors than simply relying on national-level insurance schemes. Deposit insurance is thus one of the elements of Germany s geopolitical dilemma: on one hand, Berlin wants to safeguard the stability of the eurozone, but on the other hand, it would like to minimize its own financial contributions to other eurozone countries. We saw a drama of this sort unfold in Cyprus in Cypriot banks were failing, and the Europeans, led by the Germans, refused to bail them out. The result was that banks were closed for several days and parts of deposits exceeding 100,000 euros were seized. The Germans argued

4 that the Cypriot banks were being used by Russian money launderers, hence they deserved to fail because of imprudence and Russian corruption. However, the Cypriot banks held deposits for entities that contributed significantly to the economy including the hotels at the center of the tourism industry and British retirees who had saved a few hundred thousand euros in a lifetime of work and retired to Cyprus. The latter were devastated. The former could not pay their employees for weeks, and many never recovered from the crisis. What had been an uncertain proposition putting their money in a bank in Cyprus became a suicidal position. Cyprus has still not recovered. Now Italy (which represents about 11% of the EU s GDP) is also finding itself in a banking crisis. Its banks are linked to all of Europe s banks that have bought Italian paper. It is possible for the Italian government alone to bail out the banks a move not allowed under current EU rules. But at the end of the day, Italy does not own the printing press that can help monetize the banks because that belongs to the European Central Bank (ECB). The political reality is that the ECB is heavily influenced by the Germans. In other words, the Germans control the monetary supply, but they intend to push the responsibility of solving the banking problem to the Italians. This could lead to a crisis similar to the one experienced in Greece but on a much larger scale. Essentially the Germans are demanding that, if Italian banks fail, a form of the Cyprus solution be implemented in Italy. The potential consequences for the European financial system are hard to calculate, but at the moment, German Chancellor Angela Merkel is reassessing her political position, which has eroded since the onset of the refugee crisis. The international dimension of the banking system is also at a critical stage. As the exporters crises deepen, the ability to maintain comprehensive deposit guarantee schemes is key for countries like Azerbaijan and Russia. Two factors to watch are deposit levels and capital flight. Russia has struggled with high levels of capital flight, and further outflows could indicate that efforts to promote confidence in the system are failing. At the same time, negotiations over the future of the planned EDIS will be a key indicator, both for the stability of Southern European banking systems and the relationship between Germany and the rest of the eurozone. From Russia to China and the European Union, public confidence in banking systems is a factor that affects not only financial stability, but the survival of regimes and political institutions. There is no international financial institution that can possibly deal with all these potential failures and certainly none that can deal with the social consequences. When we look at Eurasia, we see banking problems that need to be solved. The solution has three layers: first, to maintain a prudent banking system; second, to provide a reliable insurance system for deposits; third, to provide security for deposits through the government, which ultimately has the resources and an interest in political and social stability. But if prudence has already collapsed and if the insurance system is incapable of coping with the flood, only the third layer remains. However, if it is beyond the state s will or capacity to act effectively, simply put, there will be hell to pay.

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